If you speak to any investor about the state of the market, you probably won’t get very long before the topic of earnings comes up.
That’s because profit growth has been the undeniable MVP of the nine-year bull market, and traders have been conditioned to rely heavily upon it for investment cues.
Healthy fundamentals make for healthy stock moves. And if an investor cashes in the added bonus of making the right trade ahead of a blockbuster earnings report, there’s even bigger money to be made.
But Peter Cecchini, chief market strategist and head of equity derivatives at Cantor Fitzgerald, thinks investors need to stop acting like earnings are the only game in town. He has his eye on a handful of other drivers — one of which he says should be attracting equal, if not more attention.
As part of a wide-ranging discussion, Cecchini shared what he sees as the overlooked story driving markets right now, while also delving into such topics as Treasury yields and volatility.
This interview has been edited for clarity and length.
Joe Ciolli: What story is being ignored by markets at the moment?
Peter Cecchini: When it comes to equity investors who have 30 years of experience with rates that have generally been trending lower, they’ve come to believe that all that matters is earnings. That’s not to say earnings aren’t important — they’re incredibly important. They’re just not the only thing that matters. There’s also cash flow, and how you value that cash flow.
It was as good as it was going to get in mid-to-late 2017, and we can see the cost of capital is starting to rise in 2018, both because of monetary policy and profligate fiscal policy.
Ciolli: Can you explain how exactly higher interest rates affect cash flows?
Cecchini: If you look at earnings and net income margin, the latter are well above their 30-year historical average. Operating margins are actually below average, or in line with average. A big reason for that is interest payments. When interest payments are lower, it increases net income margins. Whereas for operating income, you don’t necessarily get the same benefit. We can see how important secularly-trending lower interest expense has been to cash flow.
How you discount those cash flows is affected by higher capital costs. If the rate environment is generally higher, not only do you have less cash flow to discount, but you’re valuing it at a higher discount rate or weighted average cost of capital, which lowers the value of the asset.
Ciolli: You’ve talked publicly before about a secular shift you see occurring in the rate environment. Can you walk me through that, and how it came about?
Cecchini: Something has happened at the ultra-short end of the yield curve, and it can’t be explained fully just with the Fed.
We’re in the late stages of an economic cycle, and we’ve started to implement fiscal policy that’s highly stimulative. We’ll have a budget deficit somewhere in the ballpark of $850 billion this year, reaching $1 trillion by 2019. That’s required we issue more Treasuries.
When you have that, in combination with the Fed that’s going to shrink its balance sheet in the second half of the year — along with an ECB that’s not going to be as aggressive, in combination with a Bank of Japan that’s basically going to be the same — you have marginally less accommodative global policy than you did in 2017. That’s where the shift starts.
You have marginally less accommodative global policy than you did in 2017. That’s where the shift starts.
Ciolli: A lot was made about the 10-year Treasury yield breaking 3%. Now people seem to be torn about whether or not it was a big deal. Where do you come out?
Cecchini: I’m not saying the world is ending just because interest rates are rising. What I’m saying is that investors need to start thinking about how to value assets differently, and the fact that earnings are not all that matter. They must also consider the cost of capital.
To the extent that rates are on a continuum, there’s nothing necessarily all that magical about 3% as a number. But psychology matters, and when you hit 3%, it suggests you might move to 4%. It’s the psychological signal that it sends that makes it real for people that we’re in a rising-rate environment.
Because of the psychological impact of long-term real rates — as well as the potential impact on the economy — equities will sell off. What happens then? Capital flows back into risk-free assets, and that keeps Treasurys bid and rates low. It’s not my view that the 10-year runs away on us this year. Could we see 3.5%? I suppose we could, but it’s unlikely.
Ciolli: We’ve seen much higher volatility in stocks this year, which is seen by many as a healthy sign. Are we better positioned from a volatility standpoint now than we were during 2017?
Cecchini: Equity market volatility has been quite elevated compared to volatility in other asset classes, like currencies, rates, and high-yield.
There’s still a large short-volatility position in the market, because people aren’t done covering
We’re still experiencing the benefits of a global economic recovery, and fundamentals haven’t really started deteriorating in most places. But market structure and positioning have changed quite a bit. One very popular proxy for generating yield was shorting stock market volatility. That drove volatility down and kept it down, until rates started to go up, and people realized they didn’t need to sell vol to get yield — they could just get into credit again. So they started buying back short volatility positions to close, which drove up volatility, which got people nervous, which led to more selling.
There’s still a large short-volatility position in the market, because people aren’t done covering. That’s kept volatility high, despite the fact that we’re not far from the all-time market high.
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